QUESTION 1 [2 + 2 + 2 + 2 + 2 + 2 + 4 = 16 MARKS]

It is late November 2020. Fresh out of school, you have been hired by Dunphy Asset Management,
headquartered in Sydney, Australia. Alex Dunphy is the senior portfolio manager for Australian
equities and believes that, after the recent run-up, the Australian equity market is primed for a
relatively deep downside correction between now and the end of January 2021, despite the fact that
the Reserve Bank of Australia (RBA) has recently cut the risk-free rate of interest to 0.10% p.a.
(continuously compounded). On the other hand, Alex expects the market to resume its positive trend
after the correction. She, therefore, asks you to design a strategy that eliminates the market exposure
(i.e., the systematic risk) of the domestic equity portfolio between now and the end of January 2021.
The portfolio, labelled as “HomeGrown”, is currently valued at AUD 50,000,000 and it is actively
managed.

In order to design the risk management strategy, you ask the research team to analyse the returns of
the ASX200 Spot, ASX200 Futures and of the HomeGrown portfolio.
The key findings of their report are contained in the following table.

Summary Statistics of Return – Annualized

Mean Std Dev Beta Alpha Dividend Yield
ASX 200 Spot 7.68% 13.35% 1 0% 3.20%
ASX 200 Futures 3.30% 13.45% 1 0% N.A
HomeGrown Portfolio 10.56% 18.14% 0.45 0.50% 2.7%

Note: Alpha and Beta are computed with respect to the ASX200 Spot
Dividend Yield is continuously compounded

Correlation Matrix of Returns – Annualized

ASX 200 Spot ASX 200 Futures HomeGrown Portfolio
ASX 200 Spot 1
ASX 200 Futures 0.994 1
HomeGrown Portfolio 0.329 0.315 1
Next, you look up the details of ASX200 futures that you plan to use. You observe that the available
maturities over the next 12 months are November, December, January, March, June and September,
and the index multiplier is AUD25. Finally, the ASX200 spot index has just closed at 6410.

a) What futures position (long or short) do you need to take? Why?

Note: you are not required to work out the number of contracts in this part of the question.

b) What ASX200 futures contract (i.e., what maturity) should you trade in? Explain your answer.
c) For Dunphy Asset Management, the ASX200 futures market presents essentially no-arbitrage
opportunities. If you open your futures position today (late November), at what futures price
should you, then, expect to trade, given your answer in b)?
Round to 4 decimal digits at each step

d) How many contracts do you need to buy or sell in order to achieve the hedging objective set by
the senior portfolio manager?

e) Does the hedging strategy that you recommend above leave the HomeGrown portfolio exposed
to basis risk? Why or why not?

f) Given the data above and given the hedging strategy you recommend, what do you expect the
return on the hedged HomeGrown portfolio to be between late November 2020 and late January
2021?

g) You also call a bank that quotes you a 2-month forward price of 6400.00 for the ASX200. Dunphy
Asset Management prefers to stick with futures and does not want to hear about arbitrage
strategies for the HomeGrown portfolio. However, you can legally advise your good friend
George Costanza about those opportunities. Mr. Costanza was given by his generous father-in-
law a $100,000 equity portfolio which closely mirrors the ASX200. Do you see a free-lunch
opportunity for Mr. Costanza? If so, what trading strategy would you recommend Mr. Costanza
to implement on his own portfolio? Provide the details of the trading strategy and, hence, of the
$ amount of the arbitrage profit (if any).
QUESTION 2 [3 + 3 = 6 MARKS]

A farmer is concerned that the price of wheat will drop by the time he is ready to sell his crop. He,
therefore, enters into a futures contract on 5,000 bushels of wheat for 250 cents per bushel. The
exchange requires the farmer an initial margin of $3,000, with a maintenance margin of $2,000.

a) What price change would lead to a margin call for the farmer?

b) Under what circumstances could the farmer withdraw $1,500 from the margin account?
QUESTION 3 [1 + 2 + 1 = 4 MARKS]
An investor believes that there will be a big jump in a stock price, but he is uncertain as to the
direction. A call with a strike price of $60 costs $6. A put with the same strike price and expiration
date costs $4.

a) Given his beliefs, which one of the following strategies makes sense for the investor?
1. A Long Straddle
2. A Short Strangle
3. A Butterfly Spread
4. A Bull Spread using Puts
Choose one and explain your choice

b) Construct a table that shows the payoff and profit/loss from the strategy you chose in a) above.

c) For what range of stock prices would the chosen strategy lead to a loss?
QUESTION 4 [4 + 2 + 2 = 8 MARKS]

Gloria Delgado owns 500 shares of Rio Tinto stock, listed on Nasdaq. Today is November 12th, 2020
and the stock, currently trading at $63, is already down since the time Gloria purchased it. Fearing
further declines, she decides to hedge with Rio Tinto put options with a strike of $60 and expiring in
April 2021 (a 5-month maturity). As a financial intermediary, you are willing to write the options to
Gloria and need to price them. The options are American style.

To this end, you look up the implied volatility from some traded options on Rio Tinto and sees that
it is at 35% per annum. You also check Rio Tinto stock and see that the company will pay a dividend
of $3 in 2.5 months from today and a dividend of $5 in 6.5 months from today. The Reserve Bank of
Australia (RBA) has recently cut the risk-free rate of interest to 0.10% p.a. (continuously
compounded)

a) Use a three-step binomial tree to calculate the option price.

Round u and d to 7 decimal digits so that the tree recombines.
For all other calculations, round to 4 decimal digits at each step.

b) What do you need to do in order to delta hedge the option? Be specific about the necessary
hedging strategy. Round to 2 decimal digits.

c) An analyst working for the intermediary questions your choice of the pricing model and claims
that you should have used the BSM model. How would you defend the choice of using the
Binomial model?
QUESTION 5 [3 MARKS]

A stock price is currently $50. It is known that at the end of six months it will be either $60 or $42.
The risk-free rate of interest with continuous compounding is 12% per annum. Using no-arbitrage
arguments (NOT risk-neutral valuation) calculate the value of a six-month European call option on
the stock with an exercise price of $48.

NOTE: since you are required to use the no-arbitrage approach, you will not be given marks
if you use the risk-neutral valuation approach.

Round final answer only to 4 decimal digits

QUESTION 6 [3 + 2 = 5 marks]

a) Define the basis and illustrate the concept of basis risk. Using such concept, explain what is
meant by a perfect hedge.

b) Does a perfect hedge always lead to a better outcome than an imperfect hedge in terms of:
i) Price effectively paid/received
ii) Risk

Note: You can use examples to elaborate on your answer. But, overall, your answer cannot
exceed 300 words.
QUESTION 7 [3 + 2 + 4 + 3 = 12 marks]

Key Largo Bank holds the following portfolio of options on the ASX 200

Type/Maturity Position Delta of Option Gamma of Option Vega of Option

Call 2-months -10,000 0.5 0.002 732
Call 6-months -5000 0.8 0.006 1001
Put 1- month -20,000 -0.40 0.013 841

Next, Key Largo Bank adds to its option portfolio by writing an additional 5,000 European put options
on the ASX 200. They all have a strike price of 5400 and a maturity of 3 months. Currently the ASX
200 is at 5200, the annualized risk free rate in Australia is at 2%, the dividend yield on the ASX 200
is 3.2% p.a., (both risk free rate and the dividend yield are continuously compounded) and the
volatility is expected to be 30% per annum.
Assume that each option is written on 1$ times the index value

NOTE:
For all answers show your calculations.
For underlying asset units and number of options contracts, round to the nearest integer.
In part a and b, round d1 and d2 to 2 decimal digits only when you need to compute the normal
probabilities from the Normal Table. For all other calculations, including d1 and d2, round to
4 decimal digits at each step.

a) Using the BSM model, compute the delta, gamma and vega of the bank’s position in the additional
options (the puts with a strike of 5400 that the bank has written).

b) Verify that gamma for the newly traded options (again, the puts with a strike of 5400) is
approximately correct by recomputing their delta following an upward move of 5 points in the
ASX 200.

c) How does the new trade in European puts (the puts with a strike of 5400 that the bank has written)
change the overall delta, gamma and vega of Key Largo Bank? Specifically, compute the delta,
gamma and vega of the bank’s overall position after the trade and carefully explain what each
number means.

d) The bank is especially concerned about an increase in the volatility of the ASX 200 and wants to
hedge its option portfolio against such risk, while making the portfolio delta neutral as well. To
this end, the bank considers yet another trade in ASX options. Specifically, they look at a 2-month
call with a strike of 5300. This option has a delta of 0.4538 and a vega of 837.2696. What should
Key Largo Bank do in order to achieve its hedging goals? Again, assume that each option is
written on 1$ times the index value.
Question 8 [3 Marks]

Tim Whatley is relatively new to the world of derivatives, having been involved with them only over
the past 2-3 months. He is considering European calls and puts on the AUD/USD FX rate and asks
his good friend Newman for advice.
Newman is a seasoned option trader and tells Tim that, if the level of the premium is his main concern,
he could buy a European call and an European put options on the AUD/USD FX rate for the same
premium, as long as he can find them with a strike price that equals the current Forward FX Rate.
Tim is puzzled as, despite his lack of experience he is very clear on the fact that call options and put
options carry very different rights and obligations and, therefore, cannot agree with Tim’s claim that
they would trade at the same premium.

Who do you agree with and why? (You can assume that AUD/USD currency options are priced so
that arbitrage opportunities are not available to Newman)
Question 9 [2 + 2 +2 + 2 + 1 +1 = 10 Marks]

It is November 12th, 2020 and you are looking at the screen reported below. On a different screen (not
shown) you see that the S&P500 dividend yield is 1.80% (per annum, continuously compounded)
and that the USD Libor is at 0.1403% (also per annum and continuously compounded)

Consider the 3575 December 4th. Call and Put. from the screenshot below. Your friend Howard
Wolowitz, a well-known guru in the options market, tells you that over the life of the two options,
the S&P500 will pay a cumulative dividend with a present value (as of today, November 12th.) of
$9.0454

Please note: IV in the table represent the annualized implied volatility of the option.

In part a, b and c, please use the discrete dividend amount provided. In part e, please use the dividend
yield provided.

a) What are the respective time values and intrinsic values of the two options you are considering?

b) Are they both trading within their arbitrage bounds? Round to 2 digits at each step.

c) Does put-call parity hold for those two options?

d) Ignoring transactions costs, do you see arbitrage opportunities involving those two options?

e) Price the 3575 December 4th. call according to the BSM model (use calendar days).

f) How does the BSM price compare to the market price of the call?
Question 10 [3 Marks]

Early in the term we watched the clips from the movie Trading Places. Explain what futures positions the Duke
brothers and, respectively, the movies’ main characters (Winthorpe and Valentine) took at the start of the
trading day (i.e, before the TV announcement by Department of Agriculture). Also, explain why the Dukes
took such position.

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